March 2011 - Posts

Is inflation going up? Are we likely to see deflation instead? Will we continue the current environment of low inflation? The jury is still out. Still, it’s not too early to begin educating yourself as to what investments you may want in your portfolio given each economic possibility.

Even if you have a diversified portfolio of stocks and bonds, the wrong investment mix could cost you upwards of 2% a year. This is according to an article by Peng Chen, "The Inflation Scenario," in the September 2010 issue of Financial Planning.

If we have an extension of the current environment where the inflation rate stays under 2%, this favors a more traditional mix of global stocks and bonds.

A prolonged "Japanese" style deflation, where prices decline year after year instead of climbing, presents a different challenge. In this case, stocks, commodities, and real estate will probably do poorly while government bonds are the better choices.

However, if we return to a more normal economy where inflation averages 3.5%, the Chen study suggests that in addition to the normal mix of global stocks and bonds, you will want to add commodities to your portfolio.

Many economists fear it is politically impossible to raise taxes or cut spending enough to significantly retire our nation’s debt and that the government will employ a third leg of debt reduction, inflation. In a period of high inflation, the asset classes that will probably do best are commodities, inflation-adjusted bonds like TIPs, and real estate. To the degree that the dollar sinks against global currencies, foreign stocks and bonds may outshine their domestic counterparts.

This leaves two big questions. What scenario will play out over the next ten years? And how will you know it’s happening before it’s already old news? Unless you follow current events very closely and have a little training in economics and a lot of luck, you won’t.

In my 30 years of investment experience, the strategy I’ve seen work the best is having a wide variety of investments that do well in a variety of economic scenarios. Then keep your hands off except for periodic rebalancing. While this strategy means that in any given year you will always have winners and losers in your portfolio, over the long run the odds are good that you will do fine.

Chen’s study found that from 1970 to 2009, a portfolio with a minimum of 10% to a maximum of 30% in each of six asset classes (US Stocks, International Stocks, US bonds, TIPs, T-Bills, Commodities) out-performed portfolios that did not have commodity exposure.

While this allocation underperformed a more traditional allocation of stocks and bonds in a low-inflation environment by about 1.5%, it outperformed it by about 2% during times of moderate to high inflation. If you believe moderate to high inflation is in our future, you will seriously want to consider a portfolio similar to Chen’s.

Selecting a good mix of investment classes doesn’t have to be difficult. If you are in your employer’s 401(k) or a similar retirement plan, it’s possible that every asset class you need is represented among the plan’s investment

Rick Kahler, Certified Financial Planner®, MS, ChFC, CCIM, founded Kahler Financial Group, and became South Dakota’s first fee-only financial planner in 1983. In 2009, Wealth Manager named Kahler Financial Group as the largest financial planning firm in a seven-state area. A pioneer in the evolution of integrating financial psychology with traditional financial planning profession, Rick is co-founder and co-facilitator of the five-day intensive Healing Money Issues Workshop offered by Onsite Workshops of Nashville, Tennessee. He is one of only a handful of planners nationwide who partner with professional coaches and financial therapists to deliver financial coaching and therapy to his clients. Visit KahlerFinancial.com today!

If recent trips to the store are telling you that inflation is higher than what you read in the press, you may be right. According to Michael Kitces, editor of the financial newsletter The Kitces Report, inflation may be much higher than the modest rate the government claims.

Kitces explains that the way the government calculates the Consumer Price Index (CPI) has repeatedly changed. What previously measured the price increase in a basket of goods now measures the cost of living. The difference may seem subtle, but the impact is significant.

If a loaf of whole wheat bread costs $3.00 one year and $3.30 a year later, the price increase to the consumer is 10%. In the past, the CPI was simply calculated as the average price increase (or decrease) of the entire value of a basket of goods like clothing, gasoline, rent, and groceries.

However, in 1984 the Bureau of Labor Statistics began to modify the way it calculated the CPI. First, rather than reflect the price increase in a loaf of whole wheat bread, the BLS assumed consumers would stop buying that bread if they could substitute a less expensive item, like regular white bread or a cheaper brand. Says Kitces, “From the BLS perspective, the end result is a more accurate measure of what consumers are actually spending from year to year on goods and services to maintain their standard of living.”

Still, the original goal of the CPI, to measure price changes in goods and services, no longer applies.

Another modification made by the BLS is for adjustments in quality. For example, if the latest Blackberry smart phone cost $400 five years ago, the latest version will still cost $400 today. However, today’s latest Blackberry has far more power and better quality than those from five years ago. Thus, the BLS will contend the cost of an equivalent Blackberry has fallen and adjust the cost downward to reflect the higher quality, even though the price hasn’t changed.

These are important distinctions for us as consumers to be aware of. A simple comparison of prices for a fixed basket of goods, versus a comparison with the BLS adjustments, gives a very different perspective on inflation.

According to Shadowstats.com, using the pre-1984 model of the CPI shows price increases in goods and services averaging about 10% a year for the past decade. However, the modified CPI, which is now more a measure of the increase in the cost of living, shows an average increase of around 2%. As Kitces notes, “The CPI itself is no longer an accurate reflection of inflation, because it no longer measures a fixed basket of goods.”

This gimmickry is one reason why I am a bit gun-shy of the popular TIPS (Treasury Inflation Protected Securities) government bonds. Theoretically, the principal of a TIPS bond adjusts annually for inflation. If inflation is 5%, the principal of a $1,000 bond increases by 5% to $1,050. Yet TIPS bonds are not really tied to price inflation, but rather to the increase in the cost of living.

This raises a crucial question. If the borrower (the US government) is the sole determiner of the index that establishes its interest rate, isn’t that a huge conflict of interest? Certainly, the CPI modifications have substantially lowered the cost of borrowing to the US government.

The bottom line is the current inflation rate is about five times higher than the annual cost of living increase. Whether you're making investment decisions or estimating your household budget for next year, it's important to understand that the CPI and the rate of inflation are not the same.

Rick Kahler, Certified Financial Planner(r), MS, ChFC, CCIM, founded Kahler Financial Group, and became South Dakota’s first fee-only financial planner in 1983. In 2009, Wealth Manager named Kahler Financial Group as the largest financial planning firm in a seven-state area. A pioneer in the evolution of integrating financial psychology with traditional financial planning profession, Rick is co-founder and co-facilitator of the five-day intensive Healing Money Issues Workshop offered by Onsite Workshops of Nashville, Tennessee. He is one of only a handful of planners nationwide who partner with professional coaches and financial therapists to deliver financial coaching and therapy to his clients. Visit KahlerFinancial.com today!

Dollar Stretcher, Inc. does not assume responsibility for advice given. All advice should be weighed against your own abilities and circumstances and applied accordingly. It is up to the reader to determine if advice is safe and suitable for his or her own situation.